« Monetary policy as asset prices | Main | What standard monetary theory says about the relation between nominal interest rates and inflation »

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

Hey, look on the bright side Nick, employers aren't stupid. They hire economists when they need regressions run, and when they need policy analysis done, they often hire someone with a master's degree in international relations or public policy or business administration. Someone who can write a press release or a briefing note. (You doubt this is true? Watch a department of finance recruiting video, or read some of the comments about economists and the media in recent threads).

Students in all of those programs are required to have Econ 1000 - and if they're Carleton grads, they odds are good that they've had 1000 from the master of economic intuition himself, i.e. you.

Nick, I was also shocked by the Kocherlakota's speech. I was glad to see Krugman and then Harless criticising Kocherlakota. But I was very surprised when Williamson supported Kocherlakota:
http://newmonetarism.blogspot.com/2010/08/pk-froths.html
Any thoughts about why Williamson might be OK with Kocherlakota?

Forcing everyone to take Intro Econ is not enough. Quality of instruction is usually terrible - Scott Sumner once wrote a post called "Did confusion over S&D cause the crash of 2008?".
http://www.themoneyillusion.com/?p=2006

Well Nick, as we were discussing the other day I also was math undergrad and went straight into Phd program in economics. I did however take introductory macro as an undergrad but at the time it hadn't yet occured to me to study econ in grad school (I thought I'd be a mathemetician) so it didn't really take.

However, I think that in large part it is also a problem of how intorductory macro is taught. In my response (just after yours) to Blik on the other thread I was trying to make the point that you have to look past a literal interpretation of the models and think through the micro mechanisms. You also have to take the models simpler models as examples to illustrate a point and not as representations of any reality. I know you could say the same of physics but there is a difference, Newtonian models do really represent reality to a good approximation at low speeds. I do think a lot of teachers might be taking their models too seriously in class.

Frances: You are probably right. But you call that the bright side? OK, I suppose it is in a way, but not for our discipline. And what happens in the long run, when we're all dead? Who then will teach what? There'll be noone left.

TMDB: Paul Krugman concentrates on what he had to say about structural unemployment, and Steve Williamson on structural unemployment and balance sheets. Neither seemed to notice what he said about interest rates and deflation. And that's the really problematic part. It's only a very short part of the speech. But if there's one thing someone in power at a central bank ought to know, it's the answer to this question: "Inflation looks is running too low. Which way do we move the interest rate lever to increase future inflation, up or down?"

He just wrote down "i=r+p", and "r is exogenous", and like a good little math student, concluded "if we want to raise p, we must raise i". It's very simple math, and wrong.

Adam: I was wondering how you would respond. Let me say straight out that you obviously *do* understand economics, somehow! Maybe it's that old intro econ course you took; maybe it's what you learned going out into the world, when you had to think about it all and apply it, or maybe it's just you. (I don't have an economics undergrad degree either, BTW, though I did do sort of the equivalent to a minor, or a bit more. And I took Intro twice, for A-levels, and again at uni.

Maybe it's the teaching of intro macro, as you say (and what you say there makes sense). I just don't know.

But we can't afford the risk. Make em all take Intro.

@The money demanda blog
Easy, Williamson (a Canadian) also went from math to graduate econ!
It´s the math in them...

Nick, I was referring to (newer) posts where Krugman and Williamson were discussing Kocherlakota on interest rates. I was very disturbed by Kocherlakota on interest rates, but initially there was a total silence in the blogosphere (Scott Sumner was on a holiday) so I had no idea what others were thinking, but finally Krugman briefly mentioned Kocherlakota on interest rates. But then for some deeply mysterious reason Williamson started defending Kocherlakota on interest rates.

I would recommend that anyone interested in studying economics seriously take a math major/econ minor at undergrad. Or math major/Econ 1000 at undergrad. It's not just because a strong background in math is a huge help in graduate school. There's another reason.

Econ 1000 is where the big concepts in econ are taught. The 2000 level introduces some new big concepts and refines old ones.

You can get a very long way in terms of policy analysis with no more 2nd year econ concepts.

Advanced undergrad and grad courses spend a lot of time teaching those same basic concepts with a greater degree of technical sophistication. If you went through a BA/MA/PhD at Carleton, you would take Intro to Econ, and then *five* further courses called micro theory and another five courses called macro theory (2 of each @ 2nd year, 1 at 4th year, 1 at MA level, 1 at PhD level). It ends up being the same ideas with greater and greater degrees of technical sophistication.

An undergrad degree in something other than econ makes grad school much more interesting.

(Personally I avoided much of this by having a very unconventional undergrad at Simon Fraser University where advanced micro theory was Coase, Hayek and Popper and by doing a PhD at LSE where the conventional course sequence was replaced by a series of state of the art mini-courses Larry Summers, Nick Stern etc).

I'm not quite satisfied with my blog post, because I don't think it gets at what's really wrong with Kocherlakota's argument. I can't believe that he's as ignorant of basic economic reasoning as you conclude (and as I implicitly assume, with my umbrella analogy). There is some hypothetical world -- one with the same logic as ours but very different empirical facts -- in which Kocherlakota's argument is valid. I'm frustrated by not being smart or diligent enough to ascertain that world's characteristics with any precision, so I could explain how they are different from ours. The general idea, I think, is that the zero nominal interest rate is a sunspot that gets people to fixate on a deflationary equilibrium. What you need for that to work, I'm not sure. Wild guess: flexible prices, rational expectations, bounded uncertainty (possibly at zero), definite knowledge of certain aspects of the Fed's reaction function, certain constraints on that function, discontinuous shocks. (Think: if I were a Martian come to earth, and I observed a zero nominal interest rate, and my Martian X-ray vision allowed me to observe that the risk-adjusted marginal product of capital was exactly 1%, then I would conclude that people must be expecting deflation, and I would get a job and hoard money. If you can get enough people to act like Martians, then the zero interest rate becomes a self-fulfilling prophecy of deflation.)

TMDB: Sorry. I had missed those bits. It's just a one-liner in PK. I can't think why SW should think that passage is unobjectionable, unless he missed that bit I'm objecting to, or somehow interprets it very differently. God only knows.

Andy: Just over a year ago, I did a post arguing that the Bank of Canada should loosen monetary policy and thereby "rise" interest rates. http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/why-the-bank-of-canada-should-rise-interest-rates.html

Maybe, just maybe, that's what he is trying to say. But Jeez, if you are trying to say something like that, and you are President of the Minn Fed, and not some no-name blogger like me, and if you know that people currently frame monetary policy as setting an interest rate, and you know that people frame tightening monetary policy as raising interest rates, you make damn sure to be very very explicit, even more so than I was in that post, that you are adopting a very unconventional way of framing monetary policy. You make damn sure that people understand clearly what you are saying. He doesn't.

Instead, he is saying exactly what a math student would say, if you showed him the Fisher identity and told him that money was long run super-neutral. And he does indeed state the Fisher identity, and the super-neutrality (OK, he calls it neutrality) of money.

The hypothesis that he doesn't have a clue (despite the CV) fits the facts.

Today, Williamson elaborates further...
Deflation
I argued here that we should not be worried about deflation. In part, this was a backward-looking argument, based on the behavior of the stock of currency, along with observations about the implied inflation premium on long-term Treasuries. Now, if you have been watching bond yields recently, you will have observed two things: (i) The yields on both nominal Treasuries, and inflation-indexed Treasuries (TIPS) have both fallen; (ii) The difference in those yields (a measure of the inflation premium on long Treasuries) has also fallen. This may reflect the view of the market that, given the last Fed statement, and public statements by Jim Bullard, among others, the Fed knows something the market cannot see directly, which is that inflation is going to be much lower for an extended period, if not negative.

In this case, I agree with Kocherlakota, that the market has it wrong. As Kocherlakota argued, most of our monetary models tell us that, if the Fed maintains a constant nominal interest rate target forever, that will essentially determine the inflation rate, by way of the Fisher relation. If the Fed keeps the short-term overnight rate at 0.25% forever, and if the long-run real interest rate is 2%, the inflation rate must be -1.75%, which would be supported (roughly) by long-run growth in some monetary quantity of -1.75% plus the long-run growth rate in real GDP.

This makes deflation seem like a real possibility if the Fed maintains a target nominal interest rate of 0.25% for an "extended period," as specified in the FOMC statements since all the trouble started. However, consider this. Suppose, as seems to be implied by the last FOMC statement, that the Fed intends to hold the size of the balance sheet constant, in nominal terms, for the immediate future. Suppose that what they mean by this is that the balance sheet will remain constant until the stock of excess reserves "runs off," at which time we will go back to a "normal" policy regime. By normal policy, I mean an implicit inflation target of 2% supported by a nominal fed funds target, recalibrated at each FOMC meeting.

Now, what happens between now and the time at which excess reserves go to zero? Suppose over that period that the interest rate on reserves (the relevant policy rate when excess reserves are positive) stays at 0.25%. Suppose that the inflation rate over that period is 2% and that real GDP grows at 3%. Also suppose that the quantity of currency relative to nominal GDP is constant, implying that the stock of currency outstanding is growing at 5% per year. At this rate, excess reserves will run off in about 18 years. By that time, the majority of the MBS on the Fed's balance sheet will have disappeared, and the Fed will be back to having mainly Treasuries in its portfolio. Could this be an equilibrium path for the economy? Well, given what I specified here, it seems unlikely that banks will wish to hold excess reserves for 18 years given a real return of -1.75%. Somewhere in that 18-year period, the Fed will have to raise the interest rate on reserves, otherwise the stock of currency will be growing in excess of 5% per year, and the inflation rate will rise above 2%. Thus, if anything, the inflation risk appears to be on the up side, given stated policy. I don't see the deflation risk.

Kocherlakota does a poor job explaining why "conventional thinking" is wrong. Maybe he is relying on Bullard's "7 faces of peril" paper with a flawed model of zero inflation expectations trap. Bullard's conclusion is OK (more QE is needed), but underlying model is not.

SW (as quoted by Marcus):

"In this case, I agree with Kocherlakota, that the market has it wrong. As Kocherlakota argued, most of our monetary models tell us that, if the Fed maintains a constant nominal interest rate target forever, that will essentially determine the inflation rate, by way of the Fisher relation."

Oh Christ. Oh Christ. Oh Christ.

SW interprets Kocherlakota the same way I do, and thinks he's right. Oh Christ.

We've been at near zero for quite a while now and we are heading for deflation. There is some correlation but not necessarily causation. Doesnt this speak to the over all ineffectiveness of monetary policy in the first place? While he may be missing some basic macro teaching I think basic macro teaching is missing some attachment to the real world as well. As I understand it, monetary policy assumes the fed can increase money supply. That seems a specious claim since loans (the only way interest rates gets money into peoples hands) are driven by customers applying for them, not banks making money available for them.

Maybe if interest rates were 20% and I was getting that much income off my passbook savings, Id spend a lot more money. If my 401k was getting 20% I'd probably put a lot less into it and spend more. Yes this seems counter to monetarist thinking but maybe that is exactly how e should be thinking seeing as monetarists have been in charge for a while.

Oh Christ.

Central banks can't keep the price level and inflation rate determinate by pegging the nominal (or even real) rate of interest forever. We've known that was wrong at least since Wicksell's cumulative process. I assumed that everyone (except a few hopeless lefties and funny money guys) knew that was wrong. *Nobody's* monetary model tells us that (except a few hopeless Post Keynesian types, who are at least logically consistent, because they assume very sticky prices that don't respond to AD at all).

Oh Christ.

This is much worse than Cochrane getting Say's Law wrong. Say's Law is very nearly right, and very few people understand precisely why say's Law is wrong, and that it's money, and only money, and not any other asset, that makes Say's Law wrong.

I give up.

This isn't New Monetarism. It's got nothing to do with Monetarism at all. It's the exact opposite of Monetarism. Somebody resurrect Milton Friedman.

Gizzard: sorry. I'm in far too much despair to try to explain it to you. I've got to gather up my strength to try to explain it to people who are, by any objective measure, by far my intellectual superiors in their economic education.

Paul Krugman reads WCI. Why? Because of the comments.

Oh dear! I must clean up my language (could have been worse, I expect). I was just writing another post on this. Think I will leave it now.

I guess Kocherlakota (and Williamson) made a wonderful discovery -- the fed can keep the inflation rate constant by just holding the fed funds rate constant, since the rate of real interest is constant. It's a mathematical certainty! And makes the job so much simpler... wonder why we never thought of it.

Don't leave it. More 2x4s to the head of the dumbkoffs is a good thing.

Such a tease, Nick

Let's have it out. The false monetarists must be purged.

Karl Smith does it best - Kocherlakotaean deflation in Zimbabwe:
http://modeledbehavior.com/2010/08/25/bang-bang-kocherlokta-on-deflation/

I would suggest Williamson should try to exlain why a deflationary spiral is eventually created by pegging the nominal interest rate at the near zero level without using a mathematical equation which is valid ex-post. He should first describe what happens during a deflation, that is, define the broader deflationary environment and, then, try to explain what will be the real processes under way, especially at the macro level: excess supply in all economic sectors, falling demand? The more I read Williamson's reply, the more it looks like the general level of prices is determined exclusively by monetary variables which sounds quite different from any sort of hypothesis about the neutrality of money, it looks more like the neutrality of everything which is not money (expectations) on the general level of price (velocity of circulation? credit creation? market confidence?, productivity?).

Probably, Williamson read too carefully Keynes on expectations :-)

By the way, the only way out of this recession is raising taxes on the very very wealthy -I mean income, but especially, non-physical entities- and try to devaluate the dollar -even if it won't be so easy in the ingenious way the German used to manage it, that is, creating 15 years before an unbalanced currency area.

Oh Christ.
The all-math no-basics principles demon strikes again.
I feel sad when I remember how Pierre Fortin taught us macro at Laval in the 70's. If that math master didn't told us "Remember that each equation must represent a behavior" followed ( just in case we young doofus didn't catch it the first time) by "Never write an equation if you don't understand the behavior" at least three times each course period, he didn't told us once...
Today, I warn my students that they must understand two things : the difference between a monetary and non-monetary economy ( why Say's law is wrong in the presence of money) and what is the relationship of money and goods flowing in the balance of payments account.( I don't know a single financial journalist or minister of financeor trade that gets it) Not that the rest is meaningless but because without that,there is no hope of sound reasoning. And that "Never write an equation" thing.
In the name of simple humanity ,can I exchange my Cegep post for a Fed presidency? Or at least just give them a couple hours of basic macro?
Oh Christ!

I would describe the problem as too much focus on equilibrium, and not enough of processes that would bring about equilibrium.

"We should never, ever, let students do this. Yet we do it all the time."

I think you're on to something. I'm a math guy who read Romer's Macro text, and even though I was reading a saltwater textbook with a saltwater professor, who reinforced at every point the little voice saying 'but wait...', my main reaction in the RBC model section was 'this is so cool!' It was only later, with a bit more perspective and a bit more thought about the economics of the situation that it struck me how truly off the rails RBC theory was.

I think what we need is an intro economics class for people who already have graduate-level mathematical sophistication. It does us no good to sit in a classroom full of people who don't know calculus and are uncomfortable with algebra. But it also does us no good to start right up with the modeling without thinking about how it applies. We need something that makes explicit the manner in which our math is brought to bear on observation.

Nick,

Wrong. He actually took principles of economics from Alan Blinder at Princeton. What I'm wondering is whether you were on vacation when they did Irving Fisher in macro class.

Steve Williamson

Bill: that is a better way of describing it. Except there's zero, rather than not enough, on the process that would (or, in this case, would not) bring about equilibrium. It was what I meant by distinguishing the equilibrium thought-experiment from the stability thought-experiment.

Jacques: I have to confess, "the relationship of money and goods flowing in the balance of payments account" is something I wish my head were a little bit clearer on. Lovely story about Pierre Fortin. Yes, Pierre's way of putting it, "Remember that each equation must represent a behavior" is a very good way to try to understand what the math is telling you.

bruce: I read your comment as making a similar argument to bill woolsey. Yes, we need to know the process.

TMDB: Karl's "bang-bang" interpretation is interesting. But, even if the process bringing us to the new equilibrium happened instantly, in this case it wouldn't bring us to the new equilibrium but away from it (under any reasonable behavioural assumptions). It's more like "bang-monetary system explodes". I like to think of the infinite adjustment speed as the limiting case of the slow process. With a fixed nominal interest rate, there is no nominal anchor. The monetary units are indeterminate. The only question is whether the system explodes slowly or immediately.

Rob, Jim: on reflection. my new post wasn't really saying anything I hadn't already said here. Just laid out the Wicksellian process a little more fully.

Jed: even if the real natural rate were constant, it still wouldn't really work. (But it's easy to explain why if you suppose it changes, and since it does change, there's no harm in supposing it does).

Steve: So my conjecture was wrong about him missing intro? What then happened? You can't go from the Fisher equation to the statement that if the Fed pegs the nominal interest rate, the price level is determinate. The units are all wrong. There's no nominal anchor. Start in one equilibrium, double the time paths of all prices, (I'm assuming neutrality), and you're still in equilibrium.

Or, start in equilibrium. Let the Fed raise the whole announced time-path of nominal interest rates. By what process does this create excess demand for goods at the existing price vector, and so cause a higher rate of inflation?

Don Patinkin taught me Fisher. And David Laidler. And I read more myself.

Seems the professor in question has a practical problem of overspecialization with no generalization compounded by a mastery of a theoretical part without any vision of the whole.

In higher hemispheric learning I suspect Nick has double mastery: being the master of economic intuition, as Francis relates, as well as a master of economic analysis (sensible and thoughtful mind functioning). Perhaps he has a third mastery being among the best at economical economic education with his intro course – if he balances his masteries in his teaching.

In higher hemispheric learning an educator will first provide an intuitive picture so students get a feel for the whole: a pre-analytic vision. Then they’d bring in sensible and thoughtful analysis.

Please notice, “intuitive”; “feel”; “sensible”; “thoughtful” (thinking). Who knows where this "whole", typology of four-folded ideal types, comes from?

"Paul Krugman reads WCI. Why? Because of the comments."

Oh my. More lurking it is then.

No, no! Just act natural, and don't look at the camera.

Nick's post said: "This is much worse than Cochrane getting Say's Law wrong. Say's Law is very nearly right, and very few people understand precisely why say's Law is wrong, and that it's money, and only money, and not any other asset, that makes Say's Law wrong."

I think I'm going to actually agree with Nick. Let me put that in my terms. If an economy was all currency (basically, no currency denominated debt) and no one saved, including corporations, then Say's Law would hold. Correct?

Funny, I know a bunch of Post-Keynesian types and none of them think anything like what Nick Rowe attributes to them.

Why are you folks so down on mathematics? I like to tell people that there were two useful things I learned in high school - calculus, and how to type. I'm applying the second skill right now.

Steve

I studied economics at LSE 1961-64. My teachers were world leaders in their fields (R G Lipsey, Lord Robbins, Phelps-Brown etc); and all were advisers to governments and/or business. I understood economics as a tool to change the world rather than an abstruse academic or mathematical activity, and later was an economic policy adviser to UK and Australian Prime Ministers.

I dropped maths when I was 15, not because of lack of ability or interest but because the system and small school size (420 pupils over seven grades) limited my options. Interestingly, from 1962 UK Advanced-Level maths was a requirement for LSE economics course.

I left economics to travel in 1972, the break extended to 1985 and in 1986 I took some courses at the Australian National University as a refresher. By then the content was almost all mathematical techniques and analysis rather than policy-relevant, and I've found the situation even worse in Queensland since 1991. I recruited a number of new economics graduates and students to my policy section, all said they learned more in three months with me than in 3-4 years at well-regarded universities.

I'm not an economic modeller, but since 1966 have worked with many modellers and directed modelling. In every case, the assumptions and interpretation of results were crucial, and depended for their validity not on the technical aspects but the understanding of economics per se. In my experience, over the last 50 years the profession has moved from the primacy of a grasp of economics - how things work - to over-elaborate mathematical techniques which do not aid understanding.

I made this point in reply to Scott:

"If the Fed can peg a low-rate with little to no open-market activity, then the public believes that the Fed is communicating that the inflation rate will low for the period over which rates are held low."

Jawboning can create the disinflation. This matches the empirical facts very well. The Fed has been performing OMOs but they've been sterilized. Ergo, the the Fed moved the market with words not money. Ergo, there has not been inflation only disinflation.

Similarly, if the Fed raises the FF rate by declaring a new higher target, and achieves that end without OMO, they've convinced everyone that the future will have higher inflation.

Kocherlakota is right--within the confines of a reasonable counterfactual. So, now, all three of you are being too presumptuous.

The thin reed in his statements is about the stability of the real-rate.

Steve: I confess I'm bad at maths, and it scares me. But I do agree it's useful (I once fixed my car with the aid of the envelope theorem, seriously!). Leaving cars aside, I was trying to model one of my thesis papers, and couldn't get the math to work. Then I realised it was my intuition that was wrong, and the math was trying to tell me that. But people can make the opposite mistake too. I'm only really confident about something when the math, diagrams, and intuition, all line up and say the same thing.

But I am genuinely worried about overemphasis on math in graduate economics courses. I have anecdotes of students getting totally misled by their math, and missing things that would be obvious if they had been required to explain things verbally, or in graphs. Like a model of competitive equilibrium with increasing returns to scale. He didn't see the problem.

They never taught typing in English schools. Good calculus though, if I had paid more attention.

By the way, I've done a new post on how I interpret standard economic theory, and what it has to say about the Fisher relation. See what you think. I hope it might clarify things, one way or the other.

Too Much Fed: Nope, sorry, we disagree on that. If you've got currency, as a medium of exchange, then Say's Law is wrong, regardless of whether there's debt. And if you don't have a medium of exchange, then Say's Law is right, even if you do have savings and debt. (I'm probably alone in thinking this.)

JamesH: yes, Post Keynesians are more varied than I let on. Some are not that different from New Keynesians. It depends on their IS curve (does it slope down wrt real interest rates?) and their Phillips Curve (does it get affected by AD?)

Hey, I know how to make this crazy stuff work: The Fed plays the role of "Confidence Ferry". If the Fed keep interest rates to low it stifles demand by ruining confidence; if the Fed raises rates it show the Man On Top knows things will get better, inspiring people to lend and spend.

I don't need evidence. I don't need it.

Steve, no one is down on mathematics. The criticism is that mathematics cannot be a substitute for economics, defined as a discipline that studies actual human behavior. If economics is a science, then it is far more than math, just as physics is far more than math even though it intimately relies on mathematics. Kocherlakota is being accused of treating theories naively as mathematical equations, divorced from empirical common sense (or uncommon sense, as the case may be).

In my finance PhD program we took most of the same courses as the econ PhD students the first two years. I had a bachelors in economics, but most of the econ PhD students didn't, and I saw they could get As in the econ PhD courses with little economics intuition just by being good at learning math.

I always thought maybe they'll actually really learn the econ when they have to teach it, but perhaps teaching in econ tends to be superspecialized just like research is, so many profs at top universities still don't understand intuitively giant amounts of even basic economics.

I think I might have been the first to bring up this issue (I'm not sure) and now I see I've missed all the fun. It seems to me that there are 100 ways that the Fed could raise interest rates and simulaneously raise inflation. I would be thrilled if they would do one of those things. And there is one way they could raise interest rates and reduce inflation expectations. As a matter of fact (from the TIPS spreads responses to fed funds surprises) we know that when the Fed raises the fed funds target they happen to use the one method that reduces inflation expectations. This happens at precisely 2:15 in the afternoon, so I really doubt there is any dispute over this empirical regularity. They rely on a liquidity effect (less base money means higher fed funds rates in the short run due to sticky prices.) Because that is the method they actually use, people get very nervous when Fed officials talk about raising rates in the middle of the biggest recession since the 1930s. Am I right? If not, where have I gone off base?

BTW, in a model w/o sticky prices Steve Williamson would be right. But prices are sticky, and hence short term interest rate changes are not best explained via the Fisher equation. With a liquidity effect real rates are moving by more than nominal rates.

You have made the important point -- Kocherlakota is assuming that there is a unique equilibrium and it is stable. As I mentioned over at Angrybear, I don't think this assumption is due to ignorance of basic economics. Kocherlakota definitely knows better. The falseness of his assumption is one of the results of the sort of mathy economic theory which is on his very impressive CV.

In his academic work, he demonstrates that he is very well aware that there are always two equilibria in monetary models one of which is the non-monetary equilibrium in which money is worthless. He knows this (in spite of not taking introductory economics).

There is yet another aspect of the Kocherlakota train wreck. He seems to assume that it is undesirable to have deflation when real interest rates are normal. A balanced growth path with normal real interest rates corresponds to unemployment at the natural rate (generally assumed to be zero in Kocherlakota's academic work). In that case, according to Kocherlakota's academic work, the optimal rate of inflation is -r, that is the optimal nominal interest rate is zero.

Somehow Kocherlakota is mixing a Keynesian belief that unemployment might be lower (permanently) if the real interest rate were lower and an analysis in which unemployment is assumed to be equal to a constant (usually set to zero for simplicity).

The point is that Kocherlakota's awesome CV includes many many articles in which he argues that in the very long run, the safe short term nominal interest rate should be as close as possible to zero (the Friedman rule) yet he uses much of that equilibrium analysis to argue that the optimal safe short term nominal interest rate is higher than 0.25%.

You are right that Kocherlakota made an error which should prevent him from getting an A in economics 101. Your theory as to what went wrong doesn't fit the papers on his CV (OK I haven't read them but I know some of the closely related literature). My theory is that he thinks there are two ways of talking about economics -- rigorous math and total anything goes BS. My guess is that, since the FOMC doesn't want math, he considers BS arguments which he knows are invalid to be par for the course debate. But of course I can't read his mind.

"Why are you folks so down on mathematics? I like to tell people that there were two useful things I learned in high school - calculus, and how to type. I'm applying the second skill right now."

Others have asked who exactly is down on math. I ask: whose association of mathematics is with high school calculus? High school was about precursors to mathematics -- symbol pushing and inchoate intuition. The people being complained about are way more mathematically sophisticated.

scott sumner, you boxed krugman in, so i don't know if you will get a link from him anytime soon. or he boxed himself in. either way, glad you and nick are back from vacation.

The natural rate of interest is zero. http://bilbo.economicoutlook.net/blog/?p=4656

Low interest rates can be deflationary for a few reasons. Lower interest payments, say on car and house loans could make wages less sticky. In fact many borrower's costs are lowered. Conversely, high interest rates can add to supply side inflation, and yes to some degree decreased demand for credit.

There is the Gibson paradox as Keynes put it, low interest rates decrease inflationary pressure, house buyers feel less buying pressure, housing prices stagnate or decline despite the low interest rate. There is a lot of empirical evidence to support this now.

Do not despair, Nick. As long as the vast majority of economists continue to economy as more important than the finite world, it doesn't really matter if they believe inflation or deflation results from low interest rates. In fact it doesn't even matter whether inflation or deflation results from low interest rates. It's all angels dancing on the head of a pin.

Well Nick, I'm way late here but I'm actually gonna have to agree with Woolsey. What Williamson and Kocherlakota are doing is relying on a single equation without thinking through how it's supposed to work, a big no-no. (Of course I think Sumner does the same thing but...)

I mean, what Williamson says is what the models imply but that's because the models also imply an eventual, automatic, return to full employment. The *mechansim* by which holding the short rate low forever would cause deflation is that prices will rise so high in the short-run that they're later expected to fall.

Raising rates now does imply a higher *long-run* inflation rate but only because we get MORE deflation now until prices are so low that once full-employment is restored it must be that prices will rise.

A couple of missing words in my post: "view the"

As long as the vast majority of economists continue to view the economy as more important than the finite world, it doesn't really matter if they believe inflation or deflation results from low interest rates. In fact it doesn't even matter whether inflation or deflation results from low interest rates. It's all angels dancing on the head of a pin.

I just want to know your site's traffic numbers after PK linked to you.

Why should people be forced to take economics 101? It's not a science but it tries to disguise itself as one behind a wall of mathematical models. In economics if you can't model it it doesn't exist. But the truth is that just because you can model it doesn't mean it exist. Didn't Krugman warn economist not to fall in love with their mathematical models least they miss the forest for the trees the same way most economist missed the financial crisis.

And of course you have different schools of economics that in science would be considered research traditions. In science once your presuppositions are proved wrong they're proved wrong and that tradition branches on to another research tradition that is still in tact.

Instead that tradition--I'm thinking hear of the Chicago School--treats these basic failings as abnormalities that can be explained away. And explain it does forever and ever rather than a change any part of the presuppositions their research is based on.

That the Chicago School can find wiggle room so easily in the face of the reality of what just happened and couldn't have happened if their research tradition was correct says "this is not a science."

Being forced to take a subject whose presuppositions are suspect, which goes for all economic schools, and that tries to pass itself off as a science or is at least ambivalent about what it wants to call itself smack of indoctrination.

That can do a lot of damage to how one sees reality. How else can one explain so many economists missing the financial crisis. Was it because theory told them that they had spread out risk so widely that catastrophic failure was next to impossible. Larry Summers certainly thought so even after being presented with a speech outlining how it was much more possible than the economic consensus would admit.

Dani Rodrik who believes that an intro to economics distorts one view when the real work is being done by those with advanced degrees, tells about the criticism he received from other economist after he published an article which free trade economist though would give ammunition to the anti-free traders. This was a dishonest way for economist to proceed but perhaps the free traders felt self assured by their rock solid law of comparative advantage.

But there was another side to proceeding thus, there was factor-price equalization side. Hardly a mention of it could be heard from economists. Could it be that it would have told labor to beware.

Free trade economist went skipping on their way to save the world while planting the seeds for our ruin. They not only destroyed labor but also our political economy. They delivered it into the tender mercies of corporations and their stockholders. Their cover story was that we were all going to find jobs in clean industries so there was no problem in letting those dirty blue collar industries go to other countries.

Our government with the encouragement of corporate money and lobbyist did just that. They turned the mid-west into a rust belt with dying towns while financial services rose to be 30% of our economy. It rose until it crashed and trillions of dollars of wealth was destroyed.

Today there are close to a million financial service guys looking for jobs. They won't find them in manufacturing because we've destroyed it. Those who once practiced manufacturing are still looking for decent jobs, jobs they worked hard to make into decent jobs , jobs with pensions, health care, wage, health, and safty protections. Now what is left of unionized labor is hard pressed to hold on to the gains it has fought for because so much of the nations wealth has gone to the wealtiest that there is no blood left in the turnip for anyone, not labor or the state. (Of course the state could always tax wealth but our represenatives seem to have a problem with hurting their funding sources.)_

We were better off with a political economy in which people fight for justice rather than what we have today: one where labor's power has been denuded and where economist pontificate. If you don't believe just look where it has gotten our society to follow these pied pippers of psudo-science which they seem to take as gospel.

I elected to take economics many years ago when I was in college. Some years later one summer I decided to read Samuelson's Intro on my own. No one forced me to do it.

The frist time I was impressable the second time not so much. If I would have stopped at the first time who knows what thin ice I would be basing my thinking on today. I may have been lost to those deluded souls who look to economist for answers to our political economy. It's bad enough that you have to go search out one just to have authority when you go against the consensus.

So no, I don't want to be forced to take introductory economics especially at an impressionable age. Considering the weakness of economic presuppositions and it's posing as a science, stopping at intro-economics at an early age might have clowded my view of the forest forever.

Those who are first will be last to see that their principles are faulty. And, false principles are impossible to correct with any model and sophisticated detail: mathematical or otherwise. However, it’s important to understand that when those who profess do see, they're the best equipped to correct the fault and take the lead in solving critical problems. Indeed, I think economics is key. Marx was at least correct on that point.

Nick,

Believe me, Narayana is scary smart and he knows his economics. You should probably cut him a bit of slack for the loose language he employs in speeches he delivers to the public. (Andy: I assure you that NK knows the difference between neutral and superneutral; he likely chose the former term to convey the basic idea to a lay audience).

Nick, I found it interesting that you, like many people, appear to interpret the Fisher equation as an identity. I do not. I interpret it as a theory (originally, it expressed a theory of the nominal interest rate).

What do I mean by this? Consider two debt instruments with identical risk characteristics. One is a real bond that yields a real rate of return r. The other is a nominal bond that yields a nominal rate of return i. Now here comes the theory part: I impose a no-arbitrage-condition (what must be true if both instruments are to be held in wealth portfolios). The NAC is i - p = r, where p is the inflation rate.

Now, to say anything more than this, one should properly write down (or have at their disposal) a complete economic theory, preferably written in a mathematical language (Joseph Conrad is said to have preferred English for his novels because this language is so deliciously ambiguous), with assumptions made explicit, etc. etc. Obviously, NK was not going to do this for his audience. But let's see what he's getting at.

Rearrange the NAC above and we get the Fisher equation: i = r + p. We can use the quantity theory (with stable velocity) as a theory of inflation; i.e., p = m - g, where m is the money growth rate and g is the growth rate in the demand for real money balances. And so, together, we have:
i = r + m - g.

Now, one might take (r,m,g) as exogenous, in which case, you have a theory of the nominal interest rate. Alternatively, we might take (r,g) as exogenous, and note the equivalence between i and m. If the Fed picks i and commits to it, it is implicitly committing to a money growth rate m. The implicit assumption here is that agents adjust their expectations in line with actual Fed policy. So if i=0 and r>0, then inflation (m-g) must necessarily be negative (according to this theory).

Nick, I must have missed your point. I think you may have been trying to argue that the Fisher equation is an identity (theory free) and that NK was being stupid-silly in trying to deduce conclusions from an identity. If this was your point, I think you are wrong. One may legitimately disagree with the theory NK was proposing, but it would be wrong to suggest that there is not an underlying logic to what he was trying to say.

And by the way, the theory and scenario he brings forth reminds me a bit of Japan. Why can we not interpret the deflation in Japan as the outcome of a credible policy to maintain interest rates close to zero? And by the way Nick, when you speak of the impossibility of pegging the nominal interest rate (re: Wicksell), how do you think the Japanese have managed to do so without the predicted instability in inflation/deflation?

Finally, I have to say that when Paul Krugman revels in your dispair, egging you on for more emotional outbursts...well, you know you've done something wrong!

David,

I think that Adam P has pretty much nailed it. His point bears repeating:

"Well Nick, I'm way late here but I'm actually gonna have to agree with Woolsey. What Williamson and Kocherlakota are doing is relying on a single equation without thinking through how it's supposed to work, a big no-no. (Of course I think Sumner does the same thing but...)

I mean, what Williamson says is what the models imply but that's because the models also imply an eventual, automatic, return to full employment. The *mechansim* by which holding the short rate low forever would cause deflation is that prices will rise so high in the short-run that they're later expected to fall.

Raising rates now does imply a higher *long-run* inflation rate but only because we get MORE deflation now until prices are so low that once full-employment is restored it must be that prices will rise."

I am really tired of hearing that people who say (and/or do) remarkably silly things are scary smart.

Rob,

With all due respect, why do you repeat that bullshit? In what sense do you say he has "nailed it?" What makes this guy somehow know what THE mechanism is? I have no idea what model of the world this guy has in his head. His conclusions may be correct or not. If they are correct, it would be of some interest to have the assumptions spelled out precisely.

I can write down a precise economic model where raising interest rates now has any one of the following effects on the price-level and inflation: [1] An immediate drop in the price-level, with no inflation effect; [2] A one-for-one increase in the inflation rate; [3] etc. etc.

What is predicted to happen depends on many things, not the least of which is how the fiscal authority interacts with the monetary authority in paying interest on money and bonds. In more elaborate models where agents have to learn about things, the dynamics can become more complicated.

I have no idea what you think he "nailed." What you are really saying, I think, is that his interpretation/explanation squares with your own. If so, that's wonderful. But this does not imply that there is no logical coherence (or, indeed, empirical relevance) to the argument put forth by NK.

Cheers, DA

When I took Macro Econ, I was also becoming familiar with the mathematics of optimization. I was incredulous at the Macro-Econ assumptions made: no fixed costs, no transaction costs, homogeneous agents. I decided that Econ must be more about politics than science, and that I didn't have the stomach to deal with the likes of Milton Friedman, et al.

Recently I have seen two papers that deal directly with these fixed costs and heterogenous beliefs -- and surprise! If you do model fixed costs (Gomory and Baumol) and heterogeneous agents (Geankoplos) you get some rather surprising results. For instance: there are infinitely many ways of distributing gains from trade; and: asset price bubbles are endogenous whenever you have a spectrum of opinions and investors with access to leverage.

Given these pretty fundamental results about equilibrium processes, it seems that there is a whole lot more work to do in macro-economics. We know far too little about the dynamics to criticize each other about high-level inflation vs deflation comments.

"What you are really saying, I think, is that his interpretation/explanation squares with your own."

In a certain sense, yes, that is what I was thinking. I simply took his point to mean that in the short term, pegging the interest rate below the natural rate would lead to accelerating inflation. Am I mistaken in thinking that it is a common feature of most mainstream models of monetary policy? I thought (up until the current argument) that this was well accepted. I'm pretty sure that Nick thinks the same thing.

I viewed as more of a conciliatory argument than you did, evidently. The reason I saw Adam P's argument as conciliatory is that he is basically agreeing with NK's statement, which did include the "long term" caveat. All he was saying is that the effects in the short run (hyperinflation and deflation) were being ignored. While continuing to hold the interest rate constant, these short-term processes naturally reach an end point, and give way to the long term equilibrium that NK identified. Say under sustained deflation, the capital stock would eventually fall to the point where the marginal product of capital, which is equivalent to the natural real interest rate, becomes equal to the real natural rate, restoring full employment. At this point you would start to see the long-term inflation associated with the high rate, but only after that period of deflation.

It sounds about right to me. I'm sure that Adam P could explain it better than I have, but I certainly don't see how it constitutes bullshit.

uh, equivalent may not be the right term there, but I think you can see the point

Rob,

Perhaps "bullshit" was too strong a word. But maybe not. The theoretical properties of macroeconomic variables (which is what we are arguing here) depend critically on the underlying assumptions being made. It is hard to lay out all of one's assumptions in a forum like this (or in a talk like the one NK gave). This is why we have academic journals.

I am not sure what you have in mind by "mainstream" economic models. (Again, it would have been helpful for you to cite an example). In the models I work with, pegging the nominal interest rate below its "natural" rate is not, in itself, inflationary. Of course, I also tend to work with rational expectations models, and this makes a big difference to the theoretical feasibility of pegging interest rates. The best paper on this, I think, is by Peter Howitt's "Interest Rate Control and Nonconvergence to Rational Expectations," JPE 1992.

With respect to your comment on a sustained deflation leading to a fall in the capital stock to the point where the MPK = r and "full employment" is restored. I suspect you meant an *increase* in the capital stock (to drive down the MPK)? And in any case, MPK = r does not guarantee "full employment." For example, we have models of multiple equilibria where MPK = r, and yet, the economy is "stuck" at a low-level equilibrium.

http://en.wikipedia.org/wiki/Real_business_cycle_theory
Table 1 says investment goes sky high in booms and busts in busts. If you combine that with Alan King's observation you get finance bubbles crowding out any postulated tech shocks.

This is all just a variation on the "bomb line" fallacy from Catch-22, in which the pilots believe that if the thread line on the map showing Allied forward positions is moved, they won't have to bomb Bologna. So in the middle of the night someone sneaks in and moves the line.

Of course, in the novel, that means they don't have to bomb Bologna. But I don't think the real world works like that (usually).

DA et al:

Why the Thomas Aquinas routine? If I, or any other mere mortal, had come out with a whopper like NK did, you wouldn't hesitate point out that I didn't know what I was talking about, and probably none too gently either. So why does NK get a pass?

As for Nick despairing over the implications: You seriously can't imagine the aparently screwed-up ass backwards view leading to some really horrendous policy? I think Nick (and PK) are right to make a big deal of this. It's appalling and terrifying.

Of course, I'm just a nobody in the peanut gallery. What I think doesn't matter in the least.

...capital stock, the freshwater school postulated cause of booms and busts, is the least cyclical variable! The captured economists don't suggest forcing banks to retool car plants to wind turbines or R+D or clean up pollution, in booms. Main reason no self-consistency is funded by profits of booms, whereas Keynesian economists no conflict-of-interest. There is no human capital component or externalities in RBC wiki, so unemployment (and demographics) ignored and probably the biggest awaiting productivity gain in USA, Canada and 3rd world; pollution is ignored.

Thx Peter, was 1/2 way through novel.

My post said: "Nick's post said: "This is much worse than Cochrane getting Say's Law wrong. Say's Law is very nearly right, and very few people understand precisely why say's Law is wrong, and that it's money, and only money, and not any other asset, that makes Say's Law wrong."

I think I'm going to actually agree with Nick. Let me put that in my terms. If an economy was all currency (basically, no currency denominated debt) and no one saved, including corporations, then Say's Law would hold. Correct?"

Then Nick's post said: "Too Much Fed: Nope, sorry, we disagree on that. If you've got currency, as a medium of exchange, then Say's Law is wrong, regardless of whether there's debt. And if you don't have a medium of exchange, then Say's Law is right, even if you do have savings and debt. (I'm probably alone in thinking this.)"

If I'm remembering correctly when you talked about haircuts (or post(s) near then), you talked about saving in the medium of exchange. I tried to specify no savings. That would include the currency. Granted that may be unrealistic, but I believe my point still stands.

David, the funny thing is I was ascribing to Kocherlakota a model pretty similar to what you've spelled out but I, in my mind, distinguished the "short-run" from the "long-run" he refers to try to give it a small toehold on reality.

You seem to be saying that you believe Kocherlakota was recomending a policy based on reasoning from a stable velocity quantity theory with exogenously fixed real rate? Notice in the model as you've written it if the fed ever wants to raise i it has to raise m (since r and g are fixed exogenously). Thus raising i can only be accomplished by raising inflation.

You consider this an empirically relevent model? I'm pretty sure constant velocity quantity theory models have long been understood to have no bearing on reality. When the Fed raised its target intrest rate over 5% in 2007 whyd didn't it result in an increase in the inflation rate? I would suggest that if Kocherlakota was actually suggesting the Fed raise rates soon based on this reasoning then he's even stupider than Nick has said.

Furthermore, I don't think your really doing a great job defending him here since what your suggesting makes him, and you, appear completely idiotic.

David: "Believe me, Narayana is scary smart and he knows his economics."

I believe you. But, being really smart never stopped anyone from making daft mistakes, sometimes. But I think there's more to it than that. This is not just some random, inexplicable mistake. (And it's not, in my opinion, some "deliberate ideological" mistake either. Because he could have done much better than this, if that's what he wanted, for starters.) And the fact that Steve, and now you(?), and Jesus Fernandez-Villaverde on Mark Thoma's blog, agree with him, definitely confirms it's not random. There real big systemic problems with the economics that some people are learning (or not learning). And that Steve should be surprised that others find this controversial, is really surprising. Didn't he know what everyone else thinks, even if he does disagree?

"Nick, I found it interesting that you, like many people, appear to interpret the Fisher equation as an identity. I do not. I interpret it as a theory (originally, it expressed a theory of the nominal interest rate)."

I can interpret it either way. To my mind, Fisher identity + superneutrality = Fisher relation. I used the LHS in this post, and the RHS in my next post. (Actually, superneutrality is sufficient, but not strictly necessary, for the Fisher relation).

"Nick, I must have missed your point. I think you may have been trying to argue that the Fisher equation is an identity (theory free) and that NK was being stupid-silly in trying to deduce conclusions from an identity."

That wasn't my point. My point, which I make clearer in my next post, and which I (falsely) assumed every macroeconomist understood, was that there is a big difference between asserting the Fisher relation (superneutrality) as a (long-run) equilibrium condition, and assuming that the economy will actually move towards that equilibrium where the Fisher relation holds. If you peg the nominal interest rate forever, you certainly will not move towards equilibrium. You will move away from it. Wicksell knew that. It is assumed in every discussion of the Taylor rule. Every central banker I've ever spoken to says you have to lower nominal interest rates initially if you want to raise inflation, and then raise them again, and raise them higher than before, when you get inflation up to the new higher equilibrium. In other words, what central bankers say makes no sense whatsoever unless they understood my point.

I am still stunned that NK's speech got approval. (Or, maybe as Pres, he doesn't need it?). There are a lot of eyebrows to be collected along Sparks street.

"And by the way Nick, when you speak of the impossibility of pegging the nominal interest rate (re: Wicksell), how do you think the Japanese have managed to do so without the predicted instability in inflation/deflation?" good question. I have been asking myself the same thing. I did a post on this: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/12/why-dont-we-observe-macroeconomic-black-holes.html I don't know the answer. Yes, something is wrong with standard theory. No surprise.

But when you are a Fed Pres, and you say something that so totally contradicts standard theory, to the extent of turning the Fed's one steering wheel in the opposite direction to what every other central banker says you need to turn it to get the same results, then you really do need to know that you are saying something very radically different. He clearly didn't.

Nick: "there is a big difference between asserting the Fisher relation (superneutrality) as a (long-run) equilibrium condition, and assuming that the economy will actually move towards that equilibrium where the Fisher relation holds"

Well put mate.

Adam P:

Do you actually read what I have written before crafting your comments?

First off, I am more accustomed to reading NK's journal articles, where he carefully spells out all of his assumptions. I am not precisely sure what he meant by some of his remarks in a speech whose language was constrained by time and the nature of the audience. Perhaps because I know him, I am willing to cut him some slack. I know that he is not an idiot or ill-schooled, even if such a thought seems brings some people a peverse form of pleasure.

Second, you ask about the empirical evidence about the "model" I wrote down. (I do not consider it much of a model, it is just undergrad short-hand with tons of implicit assumptions built in). I guess this means you accept the logical validity of the argument, in which case, the defense of NK's loosely stated opinion is complete (i.e., there exists an underlying logic to his argument). To answer your question, no, I do not take the "model" overly serious. On the other hand, it is not inconsistent with what we have observed in Japan, for example. Would you care to address this point?

Third, as I make clear in my response to Rob, NK is likely disciplining his reasoning by applying the standard "rational expectations" solution concept. As Peter Howitt (JPE 1992) has shown, even a mild departure from this assumption can lead to the Wicksellian cumulative process that Nick (and others, including you, I suppose) are worried about. I have a lot of sympathy for this line of reasoning (but again, I wonder about how Japan squares with this prediction).

So, at the end of the day, NK may be right or wrong. Perhaps he hasn't heard of Wicksell. Or maybe he has and has chosen to discount it. A respectful post on Nick's part reminding NK (and the rest of us) of Wicksell and of its empirical relevance would have been entirely appropriate. Instead, he goes crazy...and with Krugman's blessings. That's embarrassing (the latter, not the former...lol).

Cheers, DA

Nick's post said: "Every central banker I've ever spoken to says you have to lower nominal interest rates initially if you want to raise inflation, and then raise them again, and raise them higher than before, when you get inflation up to the new higher equilibrium."

Does that assume an aggregate demand shock instead of an aggregate supply shock?

Nick,

As usual, you raise several good points. (You could have expressed them better in your post, but this is a different matter).

Yes, you are right that SW appears unaware of how others approach this issue. We all have a lot to learn, I guess. (I see that you have started a fruitful discussion with Steve on his blog).

Yes, Wicksell knew about the theoretical pitfalls of interest rate targeting. (Again, I am curious to see how the predictions do not seem consistent with Japan, but maybe something strange going on in Japan).

I'm not sure about relying on the "conventional wisdom" of the world's central bankers, however. What makes you so sure that they (oops, we...I guess) have it right?

I look forward to reading your next post.

Cheers,
DA

Yes I read your comment, did you?

The issue after all is not at all whether or not there exists an underlying logic to the argument in the context of some model. Kocherlakota was not giving a counter-example in a theoretical debate, he was advocating for a particular policy.

Second, that sort of "undergrad" shorthand was exactly how I read your model and what I was ascribing to Kocherlakota. I see nothing wrong with that if you yourself would understand the implications of those "tons of implicit assumptions". Clearly neither you nor Kocherlakota understand your own model.

I was giving you a hint when I pointed out that your "model", the part you wrote down, implied that the way to raise i was to raise m. You didn't find that a strange implication?

Perhaps the problem is that you left out the money market. We're thinking in undergrad shorthand remember, the usual story in such models is that increasing m lowers i and in order to raise i the Fed lowers m.

Was Kocherlakota advocating for the fed to raise i by raising m? If that is the case then then he should at least indicate how that is supposed to work given how non-standard that argument is, that is not how your undergrad shorthand model works. On the other hand, if he was saying that the Fed should raise i by lowering m then when we plug the lower m into your long-run equilibrium you get even more deflation.

The point being that raising i now is not helpful in your standard undergrad shorthand model so if that is what he is reasoning from then he's reached a completely incorrect conclusion from that model, as apparently have you. And again, he was advocating a policy so the empirical relevance of the model that he's reasoning from is of paramount importance.

Finally, I do think your "model" is inconsistent with the Japanese experience exactly because they didn't follow the path the model implies in transitioning to this "long-run" equilibrium. On the other hand, the idea that simply r < 0 in the US now and in Japan I think is consistent with observation and is consistent with a coherent theory (and by that I don't mean your "model").

David,

"it is not inconsistent with what we have observed in Japan"

I disagree. On two occasions, the BoJ started to raise interest rates (just as, presumably, the natural real rate was starting to rise toward its long-run value). On both occasions, what happened was exactly the opposite of what Kocherlakota's argument would suggest: instead of allowing Japan to make its way out of deflation, the interest rate increases were followed by declines in the inflation rate back into deflationary territory.

David,

An example of what I would consider a mainstream model is the Neo-Wicksellian model presented by Woodford in Ch. 4 of Interest and Prices.

"With respect to your comment on a sustained deflation leading to a fall in the capital stock to the point where the MPK = r and "full employment" is restored. I suspect you meant an *increase* in the capital stock (to drive down the MPK)?"

No, I meant a decrease in the capital stock due to depreciation and lack of investment, say in a situation where you have deflation and the interest rate is stuck at the zero bound. The interest rate couldn't be lowered enough to stimulate investment due to a low MPK. Eventually lack of investment results in a declining capital stock, and MPK increases.

There may be some flaws in there but that is what I meant. Increasing capital stock and declining MPK would be more consistent with the opposite situation of an investment bubble approaching the point where it pops

Andy Harless said: "I disagree. On two occasions, the BoJ started to raise interest rates (just as, presumably, the natural real rate was starting to rise toward its long-run value). On both occasions, what happened was exactly the opposite of what Kocherlakota's argument would suggest: instead of allowing Japan to make its way out of deflation, the interest rate increases were followed by declines in the inflation rate back into deflationary territory."

The underlying imbalance was not corrected?

David, actually I should modify what I said above, Kocherlakota wasn't quite advocationg raising rates *now* so I take that back.

However, he was suggesting that low i leads to deflation which does appear to imply that he believes raising i is necessary to avoid getting stuck in a deflationary equilibrium and on this my points above apply:

1) He is advocating a policy so the empirical relevance of the model he is reasoning from matters.

2) He is drawing a completely incorrect conclusion from the type model that you and I are ascribing to him. Thus your defence of him isn't so good.

What's so strange about Japan? BoJ's goal is zero inflation. They do QE/ZIRP in order to raise the natural rate when deflationary pressures emerge. They raise rates when positive inflation threatens.

David,

what Rob is saying above makes sense. Rob is using r to be the real interest rate prevailing in the economy, the whole problem is that the natural rate (call it r*) is lower than r and so the economy doesn't invest enough. The equilibrium condition is MPK = r*, not r. The slump is due to r* < r.

Thus, if the capital stock falls then MPK increases until we have MPK = r* = r and full-employment is restored.

Rob,

The mainstream model you cite assumes perfect financial markets, no money, and sticky prices. Even Woodford has abandoned it. Nevertheless, I see where you're coming from now. However, I stand by my earlier point that the condition MPK = r* is no guarantee of "full employment" equilibrium. I can write down a model, for example, where MPK = r* at two (or more) levels of capital, one which Pareto dominates the other. (A simple way to do this would be to assume some form of increasing returns in the production function). Such a model has a "Keynesian" flavor to it; i.e., where a "depression" is the outcome of expectations coordinated on a low-level of activity.

Regards,
David

Adam P:

I like your comment: "Clearly neither you nor Kocherlakota understand your own model."

O.K., so maybe I truly am clueless. I do, however, fancy myself as someone with an open mind. And so, in the interest of possibly learning something significant, allow me to an extend the following offer to you.

I am willing to invite you to give a seminar on this topic at the St. Louis Fed sometime this fall. All expenses paid. Time limit: 1 hr. Audience: myself and various members of our research department. I am willing to accept instruction throughout the day (before and after the seminar). Afterward, I offer my impressions of what I have learned (we can do this at the bar). Beer purchases financed by the loser of sequential foosball games (optional).

What say you?
Email me: andolfatto@stls.frb.org

David: Oh Christ! You realise that Adam lives oceans away, is very good at fuBball, and drinks beer like a fish?

Nick,

So much for my rational expectation! ;)

I'll have to live with my commitment, however (subject to
our travel budget, of course).

And please let me know whether you'd like to visit the Fed one day!
I'd love to see you and Steve in a room, duking it out...

David

Here's a thought: we ask for WCI session at the CEAs in Ottawa next year. We all kick in a certain amount for beer.

I’ll briefly explain what I mean by “economical economic education” to frame an education system – which you already have really (nothing new, just refreshing with two eyes) - to teach intro economics with higher hemispheric learning. By “economical” is simply meant efficient: ability to teach more in less time with better results.

I did an action research project about 20 years ago that addresses the problem of so many 10 to 12 yr olds loosing love of learning at that age. I used Ockham’s razor (“law of economy”) in two principle ways: “entities must not be multiplied beyond necessity” as well as recognizing that simplicity is an aspect of structure: for depth perception the right higher hemisphere synthetic picture of the whole ideally mesh with the left hemisphere’s analytical assumptions.

First, the established teaching curriculum for Grade Four students was set to spend 80% of the time on reading, writing, math and science. I was able to reduce the time taught on these subjects to 50% with better learning outcomes. The proof was with the Canadian Test of Basic Skills administered at the beginning and end of the year.

Example of one program: built an observation beehive for students to observe and get a feel for the synthetic whole, then developed lesson plans for analysis with reading, writing, math and science around those observations. This opened up 50% of the school day (after lunch) for daily PE; drama; gardening (lesson plans like the beehive) and group dynamics in general (I do socio-metric testing to determine leadership, followers, alienates and isolates). I submit, it was a very economical and highly successful. The students loved to learn.

Onto university education in economics, where actually you already have such a system and probably use it as standard economics in your intro class: the famous circular flow diagram (“beehive”) of Household and Firm with the flow of Factors of Production and Goods & Services. Who originated it? Its brilliant!

As an isolated up-in-the-air system, it’s heavenly. The main problem is coming to ground in reality, which you can't do if your assumptions are off the mark. Frankly, I see a form of Gresham's law at work, not economically where quantities of bad money drive good money but philosophically where bad qualities (selfishness) drives out good qualities (enlightened self-interest of ego and empathy).

On the economic analysis side work for an intro course I’d use Jevons: simply defining economic analysis as the “mechanics of self-interest and utility”. Self-interest is the centering principle; utility (ordinal preference function) the marginal principle. This is status quo standard economics eh. Just keep it simple for your students in the intro class. For methodology little math is fine but more analytical reasoning (excluded middle) is better and synthetic reasoning (dialectic which includes the middle) has a place too. Interestingly, when teaching arithmetic (i.e. drilling multiple tables) in the above action research project, the carrot after hard work was to play logic games and puzzles. They loved it.

Now, in applying the law of economy to gain depth perception meshing the two sides. Personally, I’ve never seen a circular flow chart with something in the middle. Self-interest is quite a phenomenon there; as is utility at the margin, though both principles have flaws that need revision in my worldview. Self-interest (natural) is not selfishness (cultural); and, revising preferences can wait. I had quite a battle with Herb Gintis in the 90s on the topic.

I don't think that you can say that Woodford has abandoned it. He still refers to it as the "canonical" and "basic New Keynesian model" and refers to his more recent models as "extensions" of that model (w/ Curdia Aug & Oct 2009, 2010). My understanding is that he argues that the extended models (with credit spreads, etc.) give similar results as the basic model, and that the basic model is still valid

If there has been some radical paradigm shift, then I am unaware of it.

Well David, that's a friendly offer and in principle I'd like that. However, I don't think you really expect or want me to come to talk about the mechanics and implications of undergrad shorthand models so I can only assume the offer is somewhat disingenuous.

So I guess we'll just leave the conversation there, no point talking past each other any more. Sorry if you think I didn't give your point its due consideration.

As for the comment about not understanding your own model, as far as I can see it's no different, just less tactful, than what Nick said in the post so better just bring Nick to give a talk. I imagine Nick and I are anyway saying something similar.

"The relationship of money and goods flowing in the balance of payments account" is something I wish my head were a little bit clearer on"
In Introductory Macro or International Trade, there is barely a week ( well a term) without a student bringing a series of articles from a well-known financial journalist either about his own reflexions ( such as they are ) or commenting on some ministers or Chamber of Commerce type interpreting trade figures, Usually it begins by " We have a trade surplus so let's be proud of our competitivenes" followed a few days later by " We have a negative capital account so investors are fleeing" or " Our businesses are bold and forward-looking and invest outside". A few months later, a negative trade figures start the thread in reverse.
In other words, they have no understanding of what's going on. They know the arithmetical results but have no clue about the behavior. They have no understanding of why the trade and capital numbers must be equal and of opposite sign..
That's why in my course basic points it's next in importance to Say's Law in a money economy.
Third, and so related to the first it is almost the same thing, is why in a money economy there is no difference between a capitalized ans a pay-as-you-go retirement system at the macro level. (At the micro level it is of course a different story) Nobody reads "Capital accumulation with or without the social contrivance of money" anymore?
And fourth is why at the macro level of a central gov't, taxation has almost nothing to do with funding gov't expenditures but is about regulating aggregate demand.( In a century, at least one minister of finance in the western world will get it. In two centuries , the financial press...in five or six , the fresh-waterians.)
As for my students, if they get 2 out of four,it is a year well-spent.


Rob: Would you really expect Woodford to come out and say, after all these years, and in front of all his disciples, that "oops...I guess assuming frictionless financial markets and cashless economies kind of missed something?" Now, he suddenly has models with cash, banks, balance sheets, debt constraints, etc. You do not think this is a radical paradigm shift? Maybe not so radical, but pretty significant, in my view. (A New Monetarist might say that he has finally seen the light...or "a" light, at least -- evidently NMs have blind spots too).

AdamP: You've wimped out on me. And I was getting a little worried after Nick pumped you up like that! I think that Nick and I are largely reconciled on this matter (see comments on Williamson's blog).

Stephen: A WCI session at the CEAs? Brilliant! Where do I contribute? :)

David, Stephen, are you thinking of a macro-guys-fight-it-out-session or a talk-about-blogging session?

Like I said David, if I thought the offer was at all serious I'd absolutely come.

A WCI session absolutely needs to happen. How do we make it so?

On a WCI session at next year's CEA meetings. They're in Ottawa at the beginning of June this year, info can be found at economics.ca/2010/en. This is how to get a session on the program:

The conference organizer is Professor Mike Veall, Department of Economics, McMaster University, who can be reached at veall@mcmaster.ca. He welcomes suggestions for special sessions any tine, but no later than January 28, 2011. It is expected that the conference web interface for individual submissions will open December 1, 2010 and close on February 18, 2011.

Since it's in Ottawa there will probably be a large number of submission.

Sorry, wrong link, it should be economics.ca/2011/en

I agree with you, Nick, about math having to make sense, but I learned that from a math professor.

I took Econ 101 as an undergrad - I found it to be nonsense, really. I was a math/physics double major, and the single thing I most remember was what one math professor called "The Reasonableness Test." You can imagine what it was.

Those were the days not just before personal computing, but at the dawn of personal calculators. One of my physics profs allowed the use of calculators for a test (it had been forbidden before), but included one problem whose only calculation resulted in a trivial answer. The one student in the class who had a calculator - a TI SR-10 - was the one student who got it wrong.

I have a PhD in computer science, and I think my own discipline differs from economics in a fundamental way: our assumptions are tested against the reality of a machine that must execute them. Mathematics is an a priori discipline, economics should be empirical. When folks start relying on untestable a priori models, and rely on assumptions to avoid the need for empirical grounding, what one ends up with is worse than nonsense - it's nonsense that doesn't manifest as such. In CS, we call that "Byzantine error." There's nothing worse than error that hides in the confounding of unknown factors, but that kind of confounding seems to get ignored entirely in economics. I don't get that, and I don't see how the resulting discipline could possibly do more good than harm.

Something else, if you'll allow me a serial comment.

You may have heard about the Millennium Prize problems. One of those is a computer science problem, known as "P ?= NP." I think that problem's very existence speaks to your concern about economics.

Within computer science (and more broadly, mathematical logic) there's the area of computation theory, and within that, the area of decidability theory. Broadly, the issue is what is reasonably computable and what is not. Reasonably computable problems generally have deterministic algorithms that take (small) polynomial time and space to compute. Problems with only known exponential algorithms, or only non-deterministic polynomial algorithms (thus, technically, not algorithms at all) are not considered reasonably computable.

It seems to me that computer science and theology share this concern, of what is reasonably decidable or computable, and that a similar concern is missing from economics. Yes, theology, and my point in that reference is that in many respects, the modern discipline of economics appears to me even less rigorous than theology - it's more a religion than a scientific discipline, despite its apparent reliance on mathematics. Theology, like computer science, takes seriously the question of standards of proof and practicality. I seems that what economics relies upon has nothing whatsoever to do with what mathematics would consider valid standards of proof.

Economics as a profession needs to be far more than just the priesthood of the religion of capitalism, but that's how it looks to folks like me, who know what science is and know what religion is. Economics is far more the latter than the former, by my own standards of measure.

The conceptual substance of modern economics is social science - both psychology and sociology - but I see little evidence (admittedly as an outsider) that those foundational disciplines and their methods and results are taken seriously by the discipline of economics itself. I've never seen mention of a single economics "law" that isn't at its core an unproven/unprovable hypothesis about human behavior that just happens to be taken as axiom within the discipline of economics. That makes it little better than religion, and not good religion at that.

Continuing the post at August 26, 2010 at 01:15 PM ...

Here is the haircut economy "post":

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html

part of Nick's post:

"Lets start with a very simple model. No foreigners, no government. No investment. The only two goods are haircuts and money. There are no inventories of haircuts. They get produced and sold at the same time. You can't cut your own hair, and there's a tabu on cutting the hair of someone who has cut your hair recently, so you must use money as a medium of exchange. Money is a fixed stock of currency. No banks.

Start in equilibrium: demand for haircuts=haircuts produced=haircuts supplied. Desired saving=0 ..."

And, "For antiques, substitute bonds, bank loans, whatever. It doesn't matter, unless it's the medium of exchange.

The only form of excess desired savings that does the damage is an excess desire to save in the form of the medium of exchange.

Is that what you were trying to say Winterspeak? If so, you were absolutely right!"

Am I confusing the "haircut" economy with Say's law?

part of Nick's post is a comment at

November 19, 2009 at 07:55 PM

from that link

Someone asked how the Japanese were able to peg rates for so long, without the price level exploding. Andy Harless got part of it, they raised rates any time price stability was reached. But the other part is QE. Once rates hit zero the Japanese used QE. That won't work at positive rates because QE will cause the overnight rate to fall. But at zero it can't fall, so the central bank can still peg inflation at negative 0.5% by using QE to prevent runaway deflation, and by raising rates whenever price stability rears its ugly head. And that is precisely what the BOJ did. There is no mystery to be explained.

The comments to this entry are closed.

Search this site

  • Google

    WWW
    worthwhile.typepad.com
Blog powered by Typepad